​12 Types of Passive Income to Fund Your Financial Independence

In this post, I have provided some perspectives on 12 different types of passive income from the mundane to the exotic to help achieve your goals. This is part 2 to my last post Five Simple Steps to Build a Budget for Financial Freedom so you may want to start there

Creating a diverse stream of passive income serves as a hedge against risk such as rental property vacancies, stock market downturns, and the future solvency of Social Security. Once your passive income covers all of your monthly expenses, it puts an end to needing a W-2 job. Having both an adequate amount of passive income and ample free time is grasping the brass ring of personal finance. It gives us the ability to pursue our interests and best of all, you never have to put on a tie again.*

One point of clarification before we delve into the topic, in referring to passive income, I mean passive in regard to time, not necessarily in regard to tax treatment. Certain passive investments are taxed as portfolio income including income from capital gains, interest and dividends.**

1. U.S. Treasuries: Loaning Uncle Sam money is very low risk, but it is also low return. It will require a significant amount of capital invested in U.S. Treasuries, which currently yield 2.2% per year on a ten year note, to generate a worthwhile monthly return. Earning $2,200 on a $100,000 investment is barely keeping up with inflation and there far better passive investments on this list.

2. Certificates of Deposit (CD): A CD is a savings certificate issued by a bank or credit union that provides a fixed interest rate for a specific duration of time. The duration can be as short as three months or as long as several years, with the rate of return being higher the longer the duration. Some investors prefer to buy several CDs on a rolling basis, buying a CD every six months and laddering so they mature every six months which provides some interest to spend and the principal to reinvest. Current rates on a one year CDs are around 1.2% meaning the return on a $100,000 would only be $1,200 after a year. CDs are insured by the Federal government (FDIC), but the current low return make them a poor alternative to other investments.

3. Bonds: Bonds are essentially loaning money to an entity, such as a government or private sector company, which pays the bondholder back with interest. The interest is frequently paid twice a year. The rate of return is generally fixed and the yield depends on the credit rating of the entity issuing the bond. A perceived risk of nonpayment or default will mean higher returns. Some bonds issued by government entities come with tax free interest. One option is to invest in bond funds through brokerage firms like Vanguard that have low fees and diversify holdings across many bonds to reduce risk. As investors grow older bonds become more appealing as they offer more stable rates of return and less volatility.

4. Dividend Yielding Stocks: Buying a share of stock is essentially buying a small percentage of equity in a publicly traded company. Generally, if the company does well in business the shares goes up in value, if they makes mistakes, the shares fall. The company also pays out a share of profits to shareholders as a dividend. Not all stocks pay dividends, faster growing tech companies often do not as the put profits back into growing the business. Business stalwarts like GE, 3M or Johnson & Johnson can pay a solid dividend of between 2% and 3% per year on the share price. Instead of trying to pick specific stocks it can be easier to invest in a broad index of high dividend stocks through a brokerage firm. The average rate of return for the S&P 500, a broad index of 500 U.S. companies, has been about 10% per year from 1928 to 2014. This, of course, has not been a smooth progression, and there have been some nail biting years such during as the recent global financial crisis. The key to success with this investment is being able to ride out the downturn and preferably be able to accumulate more shares at the same time. As Warren Buffet says, become greedy when others are fearful. A $100,000 investment may return $8,000 to $12,000 a year in share appreciation and dividends which provides both a stream of cash and is a great hedge against inflation. Stocks are liquid, which means they can be sold and converted to cash very quickly, which can be an advantage over some of the other investments described below that lock in your funds for a longer duration.

5. Private Equity Shares: These shares are in a partnership that is publicly traded like stocks, but often have a higher annual yield, including some above 8%. The shares will rise or fall in value over time based on the performance of the business. An example is Blackstone which trades under the symbol BX. These firms are susceptible to risk if private money is not available to fund their deals or the government passes regulation that negatively affects their business model. The upside is similar to stocks in that the shares provide a stream of cash, the shares can appreciate, and the shares can be converted to cash quickly. Since these are shares in a partnership, at tax time you will receive a K-1 which will need to be reported on your tax return, although it is not difficult, you may want to check with a tax preparer.

6. Limited Master Partnerships (MLPs): MLPs are publicly traded shares in a partnership that derives its cash flow from owning assets in real estate, commodities, or natural resources. The shares will rise or fall in value based on the performance of the underlying assets and business. An example is Magellan Midstream Partners LP which trades under the stock symbol MMP. MLPs provide cash distributions to shareholders which can be 4% or more, per year, providing a higher return than traditional dividend stocks, but MLPs expose shareholders to market gyrations for the company and the underlying sector in which they are invested, such as the oil and gas sector. The shares are liquid and can quickly be converted to cash. MLPs also have different tax implications so again check with a tax preparer.

7. Real Estate Investment Trusts (REITs): REITs are similar to MLPs described above, but focus on real estate, which allows investors to have exposure to the real estate sector without actually owning a specific property. REITs pay the bulk of their profits to share holders as a distribution, which can be provide a yield of 4% to 5% a year. REITS are publicly traded and you can invest in a particular real estate asset class such as apartment buildings, senior care facilities or shopping malls. An example is AvalonBay Communities which holds many apartment buildings and trades under the symbol AVB. Shares in REITs are publicly traded so they can be easily bought and sold, unlike physical real estate. This provides the ability to sell out of the sector quickly if you suspect real estate is in a bubble and alternatively if real estate becomes undervalued, it is a great way to invest without going through the more lengthy process of buying a physical property. Similar to investing in MLPs, REITS have special tax implications, which are not difficult, but should be reviewed with a tax preparer.

8. Rental Properties: For many investors seeking passive income this is the key component of their portfolio. Rental properties are not truly passive if you are managing them yourself, but they are an excellent way to generate significant passive income. For example, if you purchase a property outright for $100,000 in cash including closing costs and it rents for $1,200 per month and your expenses (such as property taxes, repairs, and property manager) are 50% of your rent ($600) you are looking at a return of $600 per month or $7,200 per year. Not too shabby. There are also tax deductions and depreciation that apply to increase this annual return even further. I do not need to go into much detail on rentals since it is the bread and butter of the Bigger Pockets community, but it is worth noting that real estate provides you with the power of leverage. If you bought the $100,000 house above with a 20% downpayment (including closing costs) the property is actually generating $7,200 on a $20,000 cash investment. A portion of the rents will need to go towards paying the principal and interest for the duration of the loan, but the returns are now higher by using borrowed funds. If the house appreciates 3% after a year we have also added another $3,000 return on our investment. Now we know why so many millionaires built their wealth with real estate.

Unlike the other investment options listed above, physical real estate cannot always be liquidated quickly and if it is, it usually means selling at a discount. Hence, there are two key factors to keep in mind to protect this investment. First, do not become over leveraged by buying more properties with borrowed money than can be serviced by the rents or other income. The key question is can you cover the monthly payments in the event of multiple vacancies? Second, future real estate appreciation is wholly speculative. A real estate investment needs to be able to stand on its own through cashflow or improving the property to increase value. Appreciation due to rising prices is a great benefit, but it cannot be a significant factor in deciding to invest. Ignoring these two simple rules was the reason so many real estate investors went bankrupt during the global financial crisis.

9. Crowdfunding Peer to Peer Lending: Prosper and Lending Club allow investors to make investments as low as $25 in unsecured loans to individuals. The rates of return range from below 5% to over 20% depending on the credit rating of the borrower. The company issuing the loan will seek to collect in the event of default, but the key word above is unsecured. If the borrower defaults you may lose your investment. One can spread their risk by investing across a range of loans, for example investing $25,000 in 1,000 loans of $25 each to individuals with different credit ratings. Peer to peer lending also appears to have worked out some if its earlier issues in the mid 2000s and the websites today are easy to use.

10. Crowdfunding for Real Estate Investments or Business Start Ups: This is the business investment version of peer to peer lending where the focus is on funding real estate projects or raising capital to launch or expand business start ups.

a) Real estate crowdfunding: Companies like RealtyShares allow individual investors to have access to a range of different real estate investments. The ability to participate in these investments may require a minimum investment of $1,500 to $5,000 or more, but the investment is secured by the underlying real estate which lowers the risk, while still offering a rate of return that can be above 8%.

b) Business start up crowdfunding: Companieslike MicroVentures provide investment opportunities in early stage businesses with the hope that the funds will enable the business to grow successfully and the underlying shares will become significantly more valuable. The potential returns depend primarily on whether the business is successful and, although the investor will have equity in the company, it can be further diluted or become worthless if the business fails. Although this is a passive investment, it is not one that will generally yield an income stream like other investments described in this post.

There are two caveats with these types of crowdfunding investments. First, as these are private investments that are not traded on a public exchange they are less liquid and there may be restrictions on how and when you can get your money out. Second, some of these types of private investments are not open everyone and are are limited to accredited investors. According to the the U.S. Securities and Exchange Commission for an individual to be considered an accredited investor, they must have a net worthof at least $1 million, excluding the value of their primary residence or have annual income of at least $200,000 each year for the last two years (or if married, $300,000 in joint income) and have the expectation of making the same amount this year. In the wake of the financial crisis the government is trying to make sure people have some experience before launching into these types of investments. There has been some loosening of this rule, on October 30th the SEC approved Title III of the JOBS Act, that allows non-accredited investors to participate in equity crowdfunding on registered online platforms like the two companies mentioned above.

11. Investing in Notes: Purchasingnotes allows investors to fill the role of the bank, loaning on a property that provides security and yields a regular income stream as the loan is paid back with interest. This is a topic that has been expertly covered on Bigger Pockets so I encourage readers to look at @David Van Horns BP article Five Advantages of Note Investing as well as other posts on the subject.

12. Annuities: Annuities are financial products sold by financial institutions (banks/insurance companies) designed to pay out a steady stream of payments immediately or at some future date. The cost of the annuity depends on the amount of monthly income desired. The price also depends whether the payments start immediately or are delayed to a later date and whether the payments are indexed for inflation. For example, an immediate annuity for a 50 year old that provides $1,000 per month for life costs $228,000 for a woman and $222,500 for a man. This amount is not indexed for inflation and the investor has given up control of a significant amount of their funds. Some investors like the idea that they are immune to market fluctuations and will have a guaranteed income for the rest of their life. Personally, I do not see how an annuity is a better investment than many of the other investments mentioned above, but I welcome feedback from those who think annuities have a beneficial place in their portfolio.

Other Passive Investments? I am sure there are other passive investments that I have missed and I welcome comments from the Bigger Pockets community on their own positive or negative experiences with these investments. If you send me a private message I am happy to share with you my personal mix on the more liquid investments 1-7 described above.

I wish everyone the best as they seek to achieve their own passive income goals,

Nathan Carter

*An extensive clinical study of my own opinion has found that wearing a tie makes any activity exceedingly less fun.

**The above article is neither tax advice nor legal advice (because I skipped the bar exam and moved to Lebanon). Please consult an attorney, certified financial planner, or a tax professional for any related questions.